Economics

Explain why, in theory, freely floating exchange rates would automatically correct a balance of payments disequilibrium.

Under a floating exchange rate system, a system in which the exchange rate is determined solely by market forces, the balance of payments will in fact always be in harmony.

For simplicity’s sake, it is assumed that there are only two countries, the US and the UK. To reiterate once again, the US demands the British £ in order to purchase British goods and services. As for the UK, it also shares a desire to trade, and thus supplies more of its currency in order to exchange it for the US $. In a free market economy, where there is no government intervention, no trade barriers, and the cost of transportation is assumed to be nonexistent, the value of imports and exports will always be equal. For example, the UK’s demand for the £ is equal to its supply of the $, and since there is no excess currency being dumped into the market, the balance of payments will be at equilibrium. The terms of trade, ration of prices of exported goods to those of imported goods, can be used to further prove this point. The terms of trade shows how much a country can import with the revenue gained from exports, thus the value of both will always be equal.

To further clarify this example, let us assume that a factor increased the US demand for the £, thus the US supplied more of the $ in order to obtain more £. By supplying more dollars, the value of the $ declines, thus the $ depreciates. Assuming that the Marshall-Lerner Condition exists, the US’s revenue gained from exports will increase. Thus the situation automatically corrects itself, and the current account is at equilibrium.
Samar Al Ansari
Grade 12 IB